free markets is that if all markets were perfectly competitive, and if
governments allowed all prices to be determined by demand and supply,
then price would equal marginal cost for all products and the economy
would be allocatively efficient. Allocative efficiency means that resources
are used in such a way that total surplus to society—consumer surplus
plus producer surplus—is maximized. Since we discussed allocative
efficiency extensively in earlier chapters, we will say no more about it at
this point.
The other defence of free markets—what might be called the “informal
defence”—is at least as old as Adam Smith and applies to market
economies whether or not they are perfectly competitive. The informal
defence is not laid out in a formal model of an economy, but it does
follow from some hard reasoning, and over the years it has been
subjected to much intellectual probing. The informal defence of free
markets is based on three central arguments:
1. Free markets provide automatic coordination of the actions of
decentralized decision makers.
2. The pursuit of profits in free markets provides a stimulus to
innovation and growth of material living standards.
3. Free markets permit a decentralization of economic power.Automatic Coordination